Private equity investing—buying shares in non-public companies—offers state and local pension system investment managers the promise of higher returns and greater diversification. Under pressure to meet challenging investment return targets, pension system managers have increased their allocations to private equity and a related group of alternative asset classes like hedge funds and infrastructure investments.
However, there are reasons to be skeptical of public pension investment in private equity. While it is true that most private equity benchmarks outperformed the S&P 500 during the 2010s, it appears that public pension system investors did not benefit from this outperformance: their returns on public and private equity holdings were similar. Furthermore, it appears that private equity underperformed in 2020 and may not recover its edge in the decade ahead.
Over a long time period, annual returns on leveraged buyout funds are highly correlated with those of the S&P 500, raising questions as to whether private equity meaningfully adds to the diversification of pension system portfolios.
Pension systems should thoroughly evaluate the downsides of private equity investing before increasing their allocations to this asset class. These disadvantages include illiquidity, challenges in obtaining timely and accurate valuations, high investment costs, and lack of transparency.
Some of these drawbacks can be mitigated through enhanced reporting. Systems should consider emulating and building upon the best reporting practices of the California State Teachers’ Retirement System, CalSTRS, which provides a detailed list of portfolio holdings and relatively comprehensive reporting on investment fees.
An alternative to chasing the excess returns promised by private equity and other alternative asset classes is to lower assumed rates of return so that they can be achieved most of the time with a conservative mix of fixed income and public equity investments.
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